Consumer confidence is slowly returning. The University of Michigan measure of consumer confidence reached its highest post-recession level this month. Confidence remains relatively low from a long-term historical perspective, but there is little doubt now that confidence is increasing, and it's changes on the margin like this that are very important.
This has been the weakest recovery ever, and confidence has been extraordinarily low for most of the recovery. The world, in fact, has been very risk averse throughout this entire recovery. But things are changing. Gold was the beneficiary of investors' fears, rising to $1900, but now that confidence is making a comeback, gold has dropped to $1300. That's a big deal. Real yields on 5-yr TIPS fell to a low of -1.8%, as investors were willing to accept a decidedly negative real rate of return in exchange for protection from inflation and from potentially another collapse of the economy. Now, real yields have risen to -0.5%; that's a big deal too.
Risk aversion, a desire to rebuild and strengthen balance sheets, and the desire to deleverage led to a huge demand for money (e.g., the components of M2: currency, checking accounts, time deposits, and savings deposits). Never before has M2 been so high relative to national income. The bulk of the increase in M2 came in the form of bank savings deposits, which pay almost no interest at all: that is how intense the demand for money and safety has been.
But now that confidence is returning, it's reasonable to think that the world no longer wants to accumulate more and more cash and cash equivalents (i.e., money). The world may in fact soon attempt to reduce its money balances. Cash can't disappear, of course, but the desire to hold less cash can result in higher prices for other things and more economic activity (e.g., faster nominal GDP growth).
As confidence slowly returns, banks may become more willing to use their abundant supply of reserves to make more loans, and consumers and businesses may become more willing to seek out loans. Bank lending could accelerate, increasing the supply of money at the same time as the demand for money is declining. These are the ingredients for rising inflation, which up to now has been quiescent because the demand for money has been intense.
This has been the weakest recovery ever because the world has been exceedingly fearful of a lot of things. Those fears are slowly being replaced by confidence, and that means that we could be on the cusp of a sea change in the economic fundamentals, in favor of faster GDP growth and higher nominal prices (inflation). So far the only evidence of this is gold and TIPS prices and a modest rise in consumer confidence. But once this snowballs, the momentum and the magnitude of the change could become impressive. Will the Fed be able to react in a timely fashion and reverse QE in keeping with declining money demand? That could be the most important question of the next year or so.
Scott, you have written that the velocity of money is important. Is the velocity increasing?
ReplyDeleteThe velocity of money would be the inverse of the "M2 Demand" chart shown in this post. So far, no evidence of an increase in M2 velocity, but I think we should see it before the end of this year if I'm right about the gold, TIPS, and confidence indicators.
ReplyDeleteThese are the ingredients for rising inflation, which up to now has been quiescent because the demand for money has been intense.--Scott Grannis.
ReplyDeleteYes, but first they are the ingredients for increases in demand and output. Milton Friedman said that only after you get some robust growth, then inflation can set in (as the economy and labor markets return to full capacity).
We are miles from there.
in addition, we live in a globalized economy now. The Big 3 cannot set auto prices, big steel cannot set steel prices and go down the line.
Retailing is extreme now; 99 cents stores, Internet and Craigslist. Just try raising prices.
Private-sector unions are dead in the USA too.
Transportation and telecommunication have been deregged since the 1970s.
In short, we have been hearing horror stories from the Chicken Inflation Little crowd for 20 years, and instead we have dipped into deflation a couple of times. We are seeing record-low inflation now.
The Fed caused this recession by reacting to phantom inflation in 2008, and then caviling about inflation ever since.
Nor did Japan see any inflation when it conducted QE, and indeed is saw deflation when it stooped a five-year QE program, in 2006.
I have a better idea: How about some boom times, Fat City, big profits and good paydays for a while?
After many years of that, then let's have a chat about inflation.
But now? Inflation, schmaflation, fuggetaboutit.
Copper backs to 2006 levels---seven years of sideways drift.
ReplyDeleteThe Economist Commodity Index down 12 percent in last year despite a 20 percent run-up in oil prices.
I don't know when inflation will take hold again but I didn't read anything in Scott's comments that he expects concerning levels of inflation anytime soon - maybe 2 to 3% in the next couple years. Still at 3%, inflation wipes out 10% of an asset's value every 3 years.
ReplyDeleteThe fact that we haven't experienced significant inflation over the past 20 years is in itself a reason to be concerned since most folks aren't financially positioned to protect themselves from rising inflation. Major new trends tend to occur when most folks are NOT expecting them and aren't protected against them - witness the recent rise in longer term interest rates when so many individuals and institutions were heavily exposed to bonds and cash equivalents. Or even the four year old bull market in equities that most folks missed.
We can be certain of one thing: when significant inflation takes hold again most folks will not be prepared for it, like in the early 1970s. The longer we go without significant inflation, the closer we are to it re-appearance.
William: well said
ReplyDelete"The longer we go without significant inflation, the closer we are to it re-appearance."
ReplyDeleteOf course, that depends on what you're buying. As a parent who has educated 5 children through college, I can tell you that college education has completely de-linked from anything resembling reality. Undoubtedly, it will subside once I finish paying for my last child!
Confused how the M2 Demand is derived by showing how much M2 for each unit of GDP. Seems like it's backwards. Seems like M2 is over supplied to GDP (increasing M2 to GDP), which would imply a falling demand.
ReplyDeleteIs all that "huge demand for money" the reason banks cannot lend? You make no sense at all. Money is almost FREE and people still don't take it. There is no demand.
ReplyDelete